Ways to avoid hurting your credit

In general, borrowers who are required to go through a trial period before getting a permanent modification run the risk of hurting their credit if the modification reduces their monthly mortgage payments. That's because lenders report the payments to the credit bureaus as if the borrower has been paying less than the amount owed.

If the modification involves "principal forgiveness," and the lender reports your account as "settled for less than the full amount due," that can negatively impact your credit and remain on your credit history for seven years, says Barry Paperno, consumer operations manager for FICO.

But if the lender just reports the loan as modified and updates the principal balance, these changes alone should not affect your credit. That's assuming the lender keeps the modified loan under the original account number, and the report doesn't include any special comments that could be considered negative, Paperno says.

When it doubt, borrowers should ask, Magnuson says. "Have them explain to you how they are going to report this to the credit bureaus."

Tax implications

Some loan modifications affect taxes, too.

The lender reports principal reductions to the Internal Revenue Service, says Gil Charney, principal tax researcher with H&R Block's Tax Institute. In such cases, the borrower receives a tax form known as a 1099-C. Any amount reported on this form is treated as taxable income that the borrower needs to report, Charney says.

But under the Mortgage Forgiveness Debt Relief Act of 2007, you are exempt from paying taxes on that money if the debt forgiven is on a mortgage backed by your primary home. The exemption is in effect until the end of 2012.

Borrowers who are exempt will still receive a 1099-C form and will be required to include the exemption form when they file their tax returns.

The exemption does not apply to rental properties, vacation homes or second homes, Charney says.

"Unless you qualify for other exclusions, you'll have to pay taxes on that," he says.

Polyana da Costa covers mortgages and housing topics for Bankrate.com. She has been interviewed as a real estate expert by various news outlets, including ABC News Radio, CBS Radio and local NBC affiliates. She also has been cited by Forbes.com and quoted by U.S. News & World Report, the Fiscal Times and TheStreet.com among others. Connect with Polyana da Costa on Google+.

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